electric utilities and independent power producers industry primer bank of america (2006)

September 2006 Shelby G. Tucker, CFA 212.847.5085 stucker@bofasecurities.com 35 Electric Utilities, Independent Power Producers Electric Utilities Primer Everything You Wanted To Know but Were Afraid To Ask Daniel W. Scott 212.847.5638 dan.w.scott@bofasecurities.com This report has been prepared by Banc of America Securities LLC (BAS), member NASD, NYSE and SIPC. BAS is a subsidiary of Bank of America Corporation. Please see the important disclosures and analyst certification on page 134 of this report. BAS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Jairo Chung 212.847.5634 jairo.chung@bofasecurities.com Heike M. Doerr 212.847.6280 heike.m.doerr@bofasecurities.com Equity Research United States Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 2 This page intentionally left blank. Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 3 Table of Contents Putting Electric Utilities in Context 5 Setting Up a Utility Portfolio 6 Fundamental Drivers of the Electric Utility Industry 8 Operational Chain of Electric Utilities 11 What Does an Electric Utility Own? 13 Generation 14 Type of Power 15 Power Plant Technologies 16 Fuel Types 20 Transmission 23 Distribution 25 Retailing 26 Regulatory Overview 27 Who Are the Regulators? 29 State Commissions—Where the Action Is 29 Federal Energy Regulatory Commission 30 Nuclear Regulatory Commission 30 Other Regulatory Bodies (EPA/DOJ/SEC) 30 How Do Regulators Regulate? 31 Rate Case 101 31 Understanding AFUDC & CWIP 34 Stranded Assets, Regulatory Assets and Securitization 35 Deregulation 37 Deregulation—A Country Polarized 39 Evolution From a Regulated to a Competitive Model 40 Marginal Cost is King 41 Valuation Methods 45 Categorizing Electric Utilities 47 Appendix 51 Glossary 57 Fact Sheets on Power Companies 65 Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 4 This page intentionally left blank. Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 5 Putting Electric Utilities in Context “The utility sector is very difficult to cover, with the electric utility subsector presenting the biggest challenge.” Such comments are common among investors, especially those learning the sector along with other industries. A number of issues go against the sector: a lot of work for only 3.5% of S&P 500; a perception of being boring and stodgy; a steady dividend being its most redeeming quality; regulatory complexity; and, last but not least, low growth. Although many of these observations are valid, other points often are overlooked. Utilities have a relatively small weighting in the S&P 500, but is the second-largest sector in the Russell 1000 Value. The total annualized returns (with dividends reinvested) offered by the utility sector were 6.91%, 10.76% and 9.92% for one year, five years and 10 years, respectively (using the UTY); the S&P 500 returned 11.95%, 6.42% and 8.26% over the same period. The expected growth rate for the utility industry over the next three years should average 10.6%, according to First Call consensus. Coupling the capital appreciation with the dividend would imply a theoretical annual return of 13.1% over the next three years at a below- market beta (average beta is about 0.8). This primer is designed to provide investors with a basic grasp of the U.S. electric utility industry, which represents 73% of the market capitalization of all utilities (total market capitalization stands at almost $605 billion). For clarification purposes, we include electric, natural gas pipelines (including interstate pipes) and water in the utility sector; we do not include telephone or cable, although a number of utility funds can own these stocks. Independent power producers, although technically not part of utilities, are present in a number of utility indices and often are viewed as part of the sector, although they share few financial characteristics. This primer will explore such topics as primary drivers for electric utilities, operational mechanisms, regulatory structure, the impact of deregulation and the construction of a utility portfolio. We stayed away from current investment themes, as we want this report to be as valid in a decade as it is today. For the same reason, we avoided any reference to relative utility trading patterns. We also on occasion simplified some concepts in an effort to turn this primer into a more effective learning tool. First, let us quantify the size of the utility sector. Utilities are 3.5% of the S&P 500. The beta for the sector over the last 10 years has been in a band of 0.04 to 0.95, with a median of 0.51. The main utility indices to follow are the Philadelphia Utility (UTY) index, the Dow Jones Utility (DJU) index and the Utility SPDR (XLU) index. Sub- indices include the S&P Electric index, the S&P Natural Gas index, the S&P Multi- Utility index and the S&P Water index. In 2005, according to FactSet, the electric industry generated $332 billion in revenues, $82 billion in EBITDA and $23 billion in net income. Virtually all of the aggregate revenues come from domestic sales. The industry is capital-intensive, with more than $530 billion in capital spending in 2005 from electric utilities alone. Our first section caters to portfolio managers. We look at how to design a model utility portfolio within a broader market context and what are the main drivers defining the sector. In the second part, we cover the operational nature of the industry, introducing topics such as how a generation plant works. Our third segment delves into regulation and provides a tutorial on how utility rates are set. In the fourth section, we examine the impact that deregulation has had on the electric utility sector, particularly, the generation business. Finally, we conclude with a review of the most popular valuation metrics used for utilities, as well as a reference sheet for each utility. Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 6 Setting Up a Utility Portfolio In considering utilities, it is important to note their perceived role in a broader portfolio context. Although there are different flavors of utilities, the broader investment community views them as a relatively homogeneous group characterized by a relatively high dividend payout. Figure 1 traces the 15 years of dividend payout for a proxy UTY index versus the S&P 500. As the figure shows, utilities typically pay a dividend north of 60% of their earnings, while the broader market pays less than 50%. Figure 1 UTY Dividend Payout Outpaces Market Payout 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% Jun - 81 Ma r-82 Dec- 8 2 Se p -83 Jun-8 4 Mar-85 Dec - 8 5 S e p-86 Ju n - 87 Ma r- 8 8 Dec-88 Se p - 8 9 Jun-90 Mar-91 De c - 9 1 Sep-92 Ju n - 93 Ma r- 9 4 Dec-94 Se p - 9 5 Jun-96 Mar-97 De c - 9 7 Sep-98 Ju n - 99 Mar - 00 Dec-00 Se p - 01 Jun - 02 Ma r-03 Dec- 0 3 Se p -04 Jun-0 5 Mar-06 Proxy UTY Dividend Payout S&P Dividend Payout Source: StockVal, Banc of America Securities LLC estimates. Our contention is that most investors add utilities to their portfolio as a way to add income certainty but also to reduce the portfolio beta. This becomes obvious at times when investors turn defensive and utilities tend to outperform. Likewise, historically, utility dividend yields have correlated quite nicely with bonds. It is no surprise that utilities have a large retail ownership and that generally the higher the dividend payout the higher the retail ownership. It also helps utilities that most retail investors know their local utility. This creates loyalty that makes those investors less sensitive to valuation concerns. Investors need to be mindful, however, that they are not buying utilities; rather, they are buying holding companies that happen to own utilities. In most cases, the majority of earnings are generated from utility assets. As deregulation has spread, we have seen some instances where the utility (that is, noncompetitive) assets represent less than 30% of total revenue and earnings. With that in mind, what is the best way to build a utility portfolio? As Figure 2 shows, we believe that a utility portfolio starts with low beta utilities, with a solid management team (who understands how to relate to regulators) and a decent fundamental story supported by a good (and growing) dividend. The portfolio shown uses Southern, Duke (post-spin of its natural gas business), Consolidated Edison and PG&E as building blocks. Keep in mind that this foundation would have been quite different seven years ago when Southern owned Mirant, Duke owned Panhandle Eastern and a growing Duke Energy North America, and PG&E was heading to bankruptcy with a poor regulatory structure in California and a growing independent power business. The point is that investors should choose investments for which the next five years seem dominated by low-risk activities, with an emphasis on growing the dividend and maintaining a reasonable regulatory dialog. Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 7 Figure 2 Designing a Hypothetical Long-Term Utility Portfolio ED PCG Layer 1 SO DUK ETR X EL AEE FPL EXC PNM PPL D EIX AEP CMS WPS CEG SCG PNW GXP Layer 2 Layer 3 Layer 4 Source: Banc of America Securities LLC estimates. Once we establish the core, we add some more risk in exchange for incremental growth or higher dividends. In this example (Figure 2), our second layer consists of stocks that benefit from attractive demographics and a supportive regulatory framework. We also start to include names that are riskier—with exposure to commodity prices—but might have a high, but sustainable, dividend payout ratio. With the first two relatively low risk layers in place, we can now focus on adding some riskier investments. Depending on where we are in the commodity cycle, the third layer could include unregulated coal and nuclear names, as we incorporate in this example. In a time of spark spread recovery, names with exposure to combined cycle gas plants might be in favor. In the event that the U.S. government decides to implement a carbon tax or cap and trade, some of the unregulated utility companies, with a sizable nuclear fleet, would be included in layer 2 or 3. Layer 3 looks to capture structural alpha. The last layer also focuses on alpha, but on a one-off basis. We look at names that might provide a better trading opportunity at this point. The opportunity could stem from a transformational event, such as the possibility that WPS Resources might spin off its interest in American Transmission Company (ATC). Stocks that are turnaround stories would also be great candidates for this layer. In general, the turnaround angle has a relatively short time frame. Of course, the further you travel away from the core, the more flexibility you gain with your selection of stocks. The objective of the last layer is to maximize the near-term alpha. What about names that straddle a number of layers? In our example, Duke (post natural gas spin) is a core holding. However, the current Duke would be a transformational story, hence, part of layer four. In our view, in this example, the way to adjust the portfolio for that would be to overweight Duke relative to the portfolio if one believes that the spin of the gas businesses creates value for shareholders. Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 8 Fundamental Drivers of the Electric Utility Industry Before jumping into how a utility runs, in our view, a generalist should understand some of the drivers that utility specialists consider when analyzing the sector. These factors are listed in no particular order. Interest rates. Traditionally, the most significant driver of utility investments has been interest rates. In the past 30 years, interest rate movement and the electric utility sector have shown a high inverse correlation. Noteworthy is that while the correlation holds up over the long run, there has been a reversal of that trend recently. In our view, this indicates that stock selectivity remains key, as near-term stock performance choppiness persists. This is particularly evident when examining the 10-year Treasury yield versus a proxy UTY yield (our proxy UTY contains all the stocks that belong to the UTY, as the index does not include a dividend yield), as shown in Figure 3. Figure 3 Proxy UTY Versus 10-Year Treasury 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 6 / 2 8 / 1 9 9 6 9 / 6 / 1 9 9 6 1 1 / 1 5 / 1 9 9 6 1 / 2 4 / 1 9 9 7 4 / 4 / 1 9 9 7 6 / 1 3 / 1 9 9 7 8 / 2 2 / 1 9 9 7 1 0 / 3 1 / 1 9 9 7 1 / 9 / 1 9 9 8 3 / 2 0 / 1 9 9 8 5 / 2 9 / 1 9 9 8 8 / 7 / 1 9 9 8 1 0 / 1 6 / 1 9 9 8 1 2 / 2 5 / 1 9 9 8 3 / 5 / 1 9 9 9 5 / 1 4 / 1 9 9 9 7 / 2 3 / 1 9 9 9 1 0 / 1 / 1 9 9 9 1 2 / 1 0 / 1 9 9 9 2 / 1 8 / 2 0 0 0 4 / 2 8 / 2 0 0 0 7 / 7 / 2 0 0 0 9 / 1 5 / 2 0 0 0 1 1 / 2 4 / 2 0 0 0 2 / 2 / 2 0 0 1 4 / 1 3 / 2 0 0 1 6 / 2 2 / 2 0 0 1 8 / 3 1 / 2 0 0 1 1 1 / 9 / 2 0 0 1 1 / 1 8 / 2 0 0 2 3 / 2 9 / 2 0 0 2 6 / 7 / 2 0 0 2 8 / 1 6 / 2 0 0 2 1 0 / 2 5 / 2 0 0 2 1 / 3 / 2 0 0 3 3 / 1 4 / 2 0 0 3 5 / 2 3 / 2 0 0 3 8 / 1 / 2 0 0 3 1 0 / 1 0 / 2 0 0 3 1 2 / 1 9 / 2 0 0 3 2 / 2 7 / 2 0 0 4 5 / 7 / 2 0 0 4 7 / 1 6 / 2 0 0 4 9 / 2 4 / 2 0 0 4 1 2 / 3 / 2 0 0 4 2 / 1 1 / 2 0 0 5 4 / 2 2 / 2 0 0 5 7 / 1 / 2 0 0 5 9 / 9 / 2 0 0 5 1 1 / 1 8 / 2 0 0 5 1 / 2 7 / 2 0 0 6 4 / 7 / 2 0 0 6 6 / 1 6 / 2 0 0 6 8 / 2 5 / 2 0 0 6 Yield (%) Proxy Philadelphia Utility Index 10-Year Treasury Source: StockVal. The reasons for this high level of correlation are twofold. Firstly, utilities are typically a “dividend play” for investors, given their consistently high dividend payout ratio. In a rising interest rate environment, Treasury bonds generally become more appealing to investors. As investors shift asset classes, from equities to fixed income, utility stocks generally underperform. Secondly, utilities’ balance sheets carry a healthy amount of leverage to finance highly capital-intensive operations. Typically, as interest rates rise, interest expenses creep higher as utilities carry a large portion of variable rate debt, which adversely affects earnings. Rate cases, however, can allow utilities to reset revenues to cover additional interest costs. Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 9 Rate cases. Another significant driver for the electric utility industry is rate cases, particularly, for regulated utilities. Because these proceedings establish the earnings (net income) potential of the utility for future years, any reduction or increase in the components of rate calculations, such as the size of the company’s rate base, its allowed return on equity, its equity capitalization structure, or even the timing of the regulatory relief, can be a significant drag/boost on future earnings of the stock. Regulatory environment. Electric utilities are governed by many regulatory bodies. Therefore, the regulatory environment a utility operates in and the relationship a utility has with its regulators are important drivers for this space. A supportive regulatory environment is more likely to support a positive rate case outcome, making it more likely for a utility to recover its capital investments. Furthermore, a productive working relationship with regulators can lead to the utility having greater influence in shaping the market and the rules of the game in the market in which it participates. Load growth. Utility growth typically is driven by load growth in its service territory, whether through regional population growth, increased usage per customer, or through customer acquisitions. An increased customer base dilutes fixed costs while improving margins and general profitability of the utility. As shown in Figure 4, customer growth typically mirrors demographic growth. In the early 1960s, demand growth for power was about 8%. In today’s assumptions, demand growth nationwide tends to stay about 1.5-2%, with the Sunbelt states growing by as much as 4-5% per year. Figure 4 Load Growth—Especially Residential and Commercial—Follows GDP Growth -8 % -6 % -4 % -2 % 0% 2% 4% 6% 8% 10% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Residential Commercial Ind ustria l All Sectors GDP Groth Rate Source: Bloomberg, The U.S. Department of Energy. Capital investments. The electric utility industry requires significant capital investments to create opportunities for growth. Regulated utilities file rate cases to recover the costs of providing energy and to receive an appropriate rate of return on their investment. For nonregulated players, rate of return analysis is conducted prior to making the investment. In general, the level of capital investment a utility makes would provide a guideline for its long-term growth potential. Equity Research 35 September 29, 2006 Electric Utilities, Independent Power Producers Shelby G. Tucker, CFA 212.847.5085 10 Commodity prices. Commodity prices have become an important factor as some electric utilities began to transition into a deregulated market place. Earnings potential, particularly, for the names with nonregulated generation assets, largely is affected by commodity prices, mainly the spark and dark spread. The spark spread refers to the per unit margin, that is, power price less fuel cost, an operator earns for gas-fired generation, while the dark spread is the same equation but related to coal-fired generation. For example, last year’s run-up in natural gas prices drove up power prices significantly, improving the margins of gas and coal-fired providers. With deregulation in some parts of the country, nonregulated generators are no longer tied to serving a native load directly at a lower price. Nonregulated generators have greater opportunities to sell the output at prices at market prices or at prices higher than the price they would be paid if serving native load. Dividend policy. As electric utilities stocks are commonly viewed as a “dividend play,” dividend policy of the electric utilities is an important fundamental driver for this space. Although dividends may change from time to time, electric utilities tend to maintain a consistent dividend policy or to utilize its dividend policy to reflect its earnings potential. Figure 5 shows how the dividend payout ratio has changed over the years, and has remained within a range of 50-80%. Figure 5 Average Sector Dividend Payout Ratio, 1980—2006 50% 55% 60% 65% 70% 75% 80% 85% Ma r - 8 0 Mar-82 Mar-84 Mar- 8 6 Ma r - 8 8 Mar-90 Mar-92 Ma r - 94 Mar-96 Mar- 9 8 Ma r - 0 0 Ma r - 02 Mar-04 Mar- 0 6 Source: Banc of America Securities LLC, Edison Electric Institute. [...]... customers have not This points to a migration of large industrial customers (who often do not get the benefit of the standard offer) and a lack of participation from small customers 26 Electric Utilities, Independent Power Producers Shelby G Tucker, CFA 212.847.5085 35 Equity Research September 29, 2006 Regulatory Overview Electric Utilities, Independent Power Producers Shelby G Tucker, CFA 212.847.5085... 2006 Operational Chain of Electric Utilities Electric Utilities, Independent Power Producers Shelby G Tucker, CFA 212.847.5085 11 35 Equity Research September 29, 2006 This page intentionally left blank 12 Electric Utilities, Independent Power Producers Shelby G Tucker, CFA 212.847.5085 35 Equity Research September 29, 2006 What Does an Electric Utility Own? The electric utility industry traditionally... interstate exchange of electricity that occurs Traditionally, utilities run their own networks, but the FERC is pushing utilities to hand over management of these networks to Regional Transmission Networks (RTO) Some utilities have responded with the proposition of an independent transmission company, which would be owned by the utilities, as a compromise Electric Utilities, Independent Power Producers Shelby... parts of Virginia, Florida, Louisiana, parts of Arkansas and parts of Missouri, parts of Illinois) SPP (Oklahoma, Kansas and part of Louisiana, parts of Arkansas, parts of New Mexico and parts of Texas) WECC (Colorado, Wyoming, Nevada, Arizona, California, Oregon, Washington, Idaho and parts of Montana, parts of South Dakota, parts of New Mexico, Texas, and Mexico) Transmission systems are federally... electricity Hydroelectric generation provides the only method to effectively store electricity, if operating a pump storage hydro plant Operators are able to run the system during periods of costly electricity (peak day hours) and pump the water back during periods of cheaper electricity (off peak hours) Figure 14 Hydroelectric Generation Source: Atlas Electric Utilities, Independent Power Producers Shelby... Rhode Island, New York and part of Canada) RFC (Combination of formerly known as MACC, MAIN, and ECAR - New Jersey, Delaware, Maryland, Washington D.C., Pennsylvania, parts of Illinois, Wisconsin, Iowa, Missouri, Michigan, Ohio, Indiana, parts of Kentucky, parts of Virginia, and West Virginia) SERC (North Carolina, South Carolina, Tennessee, Georgia, Alabama, parts of Mississippi and parts of Virginia,... consumption is not static on a daily and/ or seasonal basis For example, throughout the year, electricity consumption is higher during the summer and winter months than fall and spring because of increased cooling and heating demand Baseload demand This demand is the bottom rung along the supply/demand electric dispatch curve, as it embodies the “base” threshold level of consumer demand Baseload generation typically... Securities LLC Understanding AFUDC and CWIP Operating a utility is capital-intensive To ensure reliable service and support additional power needs, utilities spend a large amount annually to maintain and expand their transmission and distribution systems In many states, utilities must also account for increased demand by building new power plants, which can cost billions of dollars and in some cases take... ratios 14 Electric Utilities, Independent Power Producers Shelby G Tucker, CFA 212.847.5085 35 Equity Research September 29, 2006 Type of Power Consumer demand for electric generation generally is classified into three segments: baseload, intermediate and peak By categorizing the varying degrees of demand electric utilities are better able to position their assets and control costs The segmentation also... lower voltage version of transmission Following long distance transmission, the electricity’s voltage is dropped and delivered to the end user Distribution is the most visible segment of this process—think of the power poles throughout neighborhoods and industrial parks nationwide and subject to state and local regulatory commissions This is the most fragmented piece of the power industry, more so than . 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% Jun - 81 Ma r-82 Dec- 8 2 Se p -8 3 Jun-8 4 Mar-85 Dec - 8 5 S e p-86 Ju n - 87 Ma r- 8 8 Dec-88 Se p - 8 9 Jun-90 Mar-91 De c - 9 1 Sep-92 Ju n - 93 Ma r- 9 4 Dec-94 Se p - 9 5 Jun-96 Mar-97 De c - 9 7 Sep-98 Ju n - 99 Mar - 00 Dec-00 Se p - 01 Jun - 02 Ma r-03 Dec- 0 3 Se p -0 4 Jun-0 5 Mar-06 Proxy. 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% Jun - 81 Ma r-82 Dec- 8 2 Se p -8 3 Jun-8 4 Mar-85 Dec - 8 5 S e p-86 Ju n - 87 Ma r- 8 8 Dec-88 Se p - 8 9 Jun-90 Mar-91 De c - 9 1 Sep-92 Ju n - 93 Ma r- 9 4 Dec-94 Se p - 9 5 Jun-96 Mar-97 De c - 9 7 Sep-98 Ju n - 99 Mar - 00 Dec-00 Se p - 01 Jun - 02 Ma r-03 Dec- 0 3 Se p -0 4 Jun-0 5 Mar-06 Proxy UTY Dividend Payout S&P Dividend Payout Source: StockVal, Banc of America. 50% 55% 60% 65% 70% 75% 80% 85% Ma r - 8 0 Mar-82 Mar-84 Mar- 8 6 Ma r - 8 8 Mar-90 Mar-92 Ma r - 94 Mar-96 Mar- 9 8 Ma r - 0 0 Ma r - 02 Mar-04 Mar- 0 6 Source: Banc of America Securities LLC, Edison Electric Institute. Equity Research 35 September 29, 2006 Electric Utilities,